FX Drivers

The US dollar is retaining its new found firm tone. Position adjusting ahead of next week’s key events continues to dominate, encouraged by the loss of the dollar’s downside momentum.

Softer Australian CPI (2.8% in Q3 from 3.1% in Q2 sent the Australian dollar down the most today, about 1.2% as rate hike ideas pulled back (scratched) or pushed out (into the future). The Wall Street Journal story today about a more restrained QEII and the greater take down at the ECB’s 3-month refi operations (42.47 bln euros allotted vs expected of nearer 34 bln) helped support the firmer dollar tone. Rising US yields and position-adjusting mode has seen the dollar rise to its best level against the yen since Oct 13, but offers near JPY82 seem formidable. Initial support now is seen near JPY81.20-40. The dollar is broadly higher against emerging market currencies today as well.

There a number of different forces at work today.

First, the Financial Times reports that there has been progress in talks between the US and China regarding current account deficits. Since logic dictates that only a few economic variables can be targeted at a time, it is difficult to see what domestic variables would be or should be sacrificed to bring the external account, which is partly a function of growth differentials, into balance. Color us skeptical of a real substantive quantitative agreement as opposed to some kind words about a shared objective.

Second, WSJ reports about a lite-QEII plays into the recent heavier tone of US Treasuries, but in conjunction with the FT story, plays into pre-G20 talk of a deal between the US and China: QEII lite in exchange for some yuan concessions, for which the external imbalance agreement might substitute.

It is noteworthy that the justification for QEII is not so much that the economy is headed for a double dip or that deflation looms. Rather the argument is QEII is needed because the US economy is unlikely to grow above trend, which means limited progress in achieving full employment, and without greater resource use, the risks of deflation persist. That speaks to the need for insurance (lite) not the lift support that has been discussed ($2-$4 trillion).

Third, QEII lite talk today offers contrast with the ECB’s activity. While the ECB is still perceived to be aiming for the exit, today’s 3-month tender was (expiry Jan 27) was more than expected and this coupled with a somewhat disappointing money supply figures (M3 rose 1.0% in year-over-year in Sept after 1.1% in Aug and 1.3% consensus forecast) and slower loan growth (1.2% vs 1.4% expected) suggests more gradual process. This saw euro rates ease.

The Bank of Japan meets tomorrow. While it is not expected to change policy after unexpectedly cutting rates earlier this month. However, it will be in the BOJ’s new biannual outlook that the policy signal will be sent. It is likely to lower its CPI forecast for FY11 to zero from 0.1% and more important, it may forecast a 0.5% CPI for FY2012. The BOJ has defined price stability as 1% CPI. If it does indeed forecast a CPI less than that for FY2012 would signal zero interest rate policy until FY2013. Just like the SNB go more desired currency market reaction from its inflation forecasts than from its intervention, the BOJ may hoping for similar results.